Bonds Chapt.

8 in RWJJ
Definitions:
Bond - An IOU. A loan. - A security that obligates the issuer to make specified
payments to the bondholder.
Maturity - Date when the loan is paid off.
Face Value Large single-sum payment at maturity separate from an interest payment
Coupon Rate - Annual interest payment as a percent of the face value
Note that most bonds make their interest payments semiannually.
Example: 10 year $10,000 U.S. Treasury Note with 7% coupon rate. New Issue
Maturity Ten years from today
Face Value - $10,000
Coupon Rate - 7% of $10,000 = $700 per year = $350 every six months
350 350 350 350 350 350 350 350 350 350 350 350 350 350 350 350 350 350 350 10,350
0 1
2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Who issues Bonds?
US Government - bills(< 1yr.), notes(1-10 yrs) and bonds(> 10 yrs)
Other governments
Corporations
States
Cities
School Districts
Hospitals

What is a bond worth?

Price of Bond = Value of Bond
The value of the bond is the present value of its future cash flows, discounted at the
appropriate (appropriate based on risk) current interest rate (the bonds yield)
Example: The above bond is a 10 year annuity (20 semiannual coupon payments) plus
the $10,000 face value. Assume the current interest rate (bonds yield) is 7%. What is its
price?
If we have semiannual payments, we need to use the semiannual interest rate and the
number of semiannual payments, so r = 7%/2 = 3.5% and t = 20

 1
1
FV

t
t
r r 1 r 1 r

Pr ice C

1
1
10,000

20
20
.035 .035(1.035) (1.035)

350

= 10,000
If you hold the bond for 2 years and the interest rate (yield) is still 7%, what is the bonds
value? Note there are now 16 semiannual periods remaining.

1
1
10,000

16
16
.035 .035(1.035) (1.035)

350

= 10,000
Each year the PV of the interest payments decreases (due to fewer payments) but the PV
of the principal increases (because you are closer to the time you get it). As long as the
bonds coupon rate is equal to the bonds yield (the current interest rate), the bonds price
will remain equal to its face value.
Now suppose we hold the bond for 2 years and comparable investments elsewhere are
now paying 5% (2.5% semiannually). Note the bond itself has not changed.
1
1
FV

t
1 r t
r r 1 r

Pr ice C

1
1
10,000

16
16
.025 .025(1.025) (1.025)

350

= $11,305.50

Note that the price went up

Why did the price of the bond go up?

Look at the same thing, but comparable investments are now 9% (4.5% semiannually).

 1
1
FV

t
t
r r 1 r 1 r

Pr ice C

1
1
10,000

16
16
.045 .045(1.045) (1.045)

350

= $8,876.60

Note that the price went down

Why did the price of the bond go down?

Bond values and interest rates move in opposite directions
Bond prices are usually expressed as a percentage of their face value.
Examples: 100 - Selling at par
102 - Selling at a premium (102% of the face value)
98 - Selling at a discount (98% of the face value)
Premium Price is above the face value
Discount Price is below the face value
All else equal, bonds with a higher coupon rate will sell at a premium and those with a
lower coupon rate will sell at a discount.

Yield to Maturity - Also the IRR or BEY (Bond Equivalent Yield) of the bond.
The interest rate for which the PV of the bonds future cash flows
equals its price.
What interest rate solves this?
1

1
1
FV
1
10,000

Pr ice C

t
t
16
16
r r (1 r ) (1 r )
r r (1 r ) (1 r )

11,305.50 350

Note the same r appears four times in the equation.

The solution is 2.5%. With semiannual payments, this is the semiannual yield. By
convention, we double this to get the yield to maturity of 5%. By definition, the YTM of
a bond is its semi-annual yield times two. The effective annual rate (EAR) would be
greater than the YTM. The YTM is the same idea as an APR.

You can solve this with a financial calculator, Excel, or by trial and error.
Solve for r using Excels Rate Funtion:
PV = -11,305.50
PMT = 350
FV = 10,000
t = 16
The solution is 2.5% which we double to get a YTM of 5.00%.
On Excel, if you know the exact dates (settlement and maturity dates), you can use the
Yield Function.
Yield to maturity is the rate of return you get if you hold the bond to maturity (and if
you are able to reinvest all coupon payments at that rate).
Similar bonds (risk and maturity) should have similar YTMs. In a competitive
marketplace, prices adjust to give similar bonds the same YTM. - If one bond has a
higher yield, people buy it which bids up the price, and its yield falls.
More Yield to Maturity:
$10,000 10-year bond with 2 years remaining till maturity
Coupon Rate = 7%
Price = $10,370.00
What is the yield to maturity?
$10,370.00 = 350 + 350 + 350 + 350 + 10,000
(1+r)
(1+r)2 (1+r)3 (1+r)4
(1+r)4
Note that if the price is > $10,000, the interest rates must have gone down from 7%.
In this case, r = 2.52%, and the yield is 5.03%
Interest Rate Risk - The risk of fluctuations in a bonds value due to interest rate
changes.
Note: If interest rates go up, the value of every bond goes down, but some bonds lose
more value than other bonds. The biggest factor affecting the interest rate risk of a bond
is its time to maturity. Which bond has more interest rate risk: a 2-year bond, or a 20-year
bond?
Can the price of a bond change even if interest rates dont?
Example: You bought this 7% 10-year bond 2 years after it was issued for $11,305.50.
Its yield to maturity was 5%. What is it worth in 3 years if it still yields 5%?

_____________11,305.50____________________?_______________________maturity
0
4
10
20
1
1
FV

t
t
r r (1 r ) (1 r )

Pr ice C

1
1
10,000

10
10
.025 .025(1.025) (1.025)

Pr ice 350

Price = 10,875.20
Why did the price drop?
The prices of all bonds will converge to their face amount as they approach maturity. Of
course if the price was the face amount (par value), it remains constant.
Actually, every bond has two prices:
Ask - Price a bond dealer is willing to sell a bond for
Bid - Price a bond dealer is willing to buy a bond for
Ask > Bid
Ask Bid: The difference is the spread - The profit to the dealer.
When we dont specify whether we are referring to the bid or the ask, we can assume that
the price of a bond is the midpoint between the bid and ask prices.
Government Bonds - Prices are often quoted in 32nds.
Example: 105:28 or 105-28 = 105 28/32 % of face value
= 105.875% of face value
For $1 million bond = $1,058,750
Term Structure of Interest Rates - The relationship between time to maturity and yield
to maturity. Do long-term bonds yield more, less, or the same as short-term bonds? Thats the question the term structure addresses.
Yield Curve - A graph of the term structure with YTM on vertical axis and time to
maturity on the horizontal axis.
Yield Curves can be:

Upward Sloping
Downward Sloping
Flat
An upward sloping is the most typically seen of the three.
Default Risk (or credit risk) - The risk that whoever we loaned money to will not pay
it back on time or in full.
Bond Ratings - Provided by Moodys and Standard & Poors (S&P). The ratings are
not identical, but they are close. Companies and municipalities pay to be rated.
Ceteris Paribus, the highest grade bond offers the lowest return.
There is a risk/return tradeoff.

Inflation
Inflation means a drop in the purchasing power of money. If goods cost $100 last year
and $103 today, we have 3% inflation.
CPI - Consumer Price Index - The most commonly used measure of inflation. It is
based on changes in prices of a standard basket of goods. Some say that it overstates the
inflation rate because it doesnt allow for substitution.
You calculate inflation the same way you calculate interest.
3% inflation for 10 years is (1.03)10
$100 of goods in 10 years will cost $134.39
Inflation must be considered in investment decisions.
Nominal cash flow - The actual number of dollars to be received in the future (adjusted
upwards to reflect expected inflation).
Real cash flow - Expressed in terms of time zero purchasing power.
Nominal Interest Rate - The rate of growth of your money
Real Interest Rate - The rate of growth of your purchasing power
Fisher Equation:
1 + Real Interest Rate = 1 + Nominal Interest Rate
1 + Inflation Rate
Approximation: Real Interest Rate = Nominal Interest Rate Inflation rate
Example:
Nominal interest rate = 7%
Inflation = 3%
What is the real interest rate?
1.07 = 1.0388 Real rate = 3.88%
1.03
Approximation: 7% - 3% = 4%
If inflation expectations increase, nominal interest rates increase in order to maintain
purchasing power. Note: we often refer to inflation, but its really inflation expectations
since the interest rates declared in the present are matched with inflation expectations for
the future.

To convert nominal dollars to real dollars:

Real Dollars = Nominal Dollars / (1+inflation rate)t
To convert real dollars to nominal dollars:
Nominal Dollars = Real Dollars (1+inflation rate)t
You must account for inflation in any problem involving the time value of money.
You must either adjust the dollars or the interest rate.
Nominal cash flows must always be discounted at the nominal rate.
Real cash flows must always be discounted at the real rate.
Note that at time zero, nominal dollars equals real dollars.
An important time to consider inflation is in retirement planning.
Suppose Im 25 and plan to retire at age 65
I want $60,000/yr for 35 years (I think Ill live to age 100), but what I really want is what
$60,000/yr can buy me today (the purchasing power of $60,000 each year)
Assumptions:
Inflation is expected to be level at 2%
Interest (investment) rates are 7%
How much must I save per year?
Real Interest Rate: 1.07 = 1.049 real return = 4.9%
1.02
To get a $60,000/yr annuity for 35 years in real dollars:

PVA =

1
1

35
.049 .049(1.049)

$60,000

= $994,725.79
So I need $994,725.79 of todays dollars at age 65 to be able to consume $60,000
(todays dollars) per year for 35 years.
To get $994,725.79 of todays purchasing power, what Ill actually need is $2,196,393.99
at age 65. This means converting Real Dollars to Nominal Dollars.
994,725.79 (1.02)40 = 2,196,393.99

I must save $___/yr. to get to $2,196,393.99 in 40 years.

We can most easily do this as the Future value of an annuity.
2,196,393.99 = C [(1.07)40 1]
.07
C = $11,002.04
So, if I save $11,002.04 (nominal dollars) per year for 40 yrs. at 7%, Ill have
$2,196,393.99.
But due to inflation, the $2,196,393.99 will only be worth the equivalent of $994,725.79.
However, this will be enough to generate (at 7% interest with 2% inflation), a 35-year
annuity worth the equivalent of $60,000 per year.
How much money will I withdraw from my retirement account when I turn 66?
$60,000 in real dollars
$60,000 (1.02)41 = $135,132.03 in nominal dollars
You will then withdraw 2% more (in nominal dollars) each year to keep up with inflation.
I can also determine how many real dollars I need to invest into my retirement account
each year. This is a bit more complex because it means I have to invest a different amount
of money (in nominal dollars) each year, but it means that Im setting aside the same
purchasing power each year.
Discount real dollars at the real interest rate:
994,725.79 = C [(1.049)40 1]
.049
C = 8,433.56
So each year, you set aside $8,433.56 of todays purchasing power.
In nominal dollars, this is:
$8,433.56 (1.02) = $8,602.23 at age 26
$8,433.56 (1.02)2 = $8,774.28 at age 27
$8,433.56 (1.02)3 = $8,949.76 at age 28
etc.

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